Does Stock Market Diversification Still Work?

It's understandable that some investors have come away from the steep market decline in 2008 and 2009 believing that diversification no longer works. They were dismayed that U.S., international and emerging stock markets all declined together and that most bond prices fell, offering only limited protection against the market collapse.

Diversification does help, however, and it always has — even if, during extreme times, it hasn't been able to prevent losses entirely. It's true that, with the exception of government securities, all investment sectors were hit by the 2008-2009 decline. But investors with a diversified portfolio of stocks and bonds lost a lot less than those with an all-stock portfolio — even one that included international or emerging market stocks.

Diversification also worked for investors during the first bear market of this decade: the 2000-2002 dot-com decline.

A closer look at the investment returns of a 100% U.S. stock index compared with a diversified investment mix of 60% stocks and 40% bonds between December 31, 2007, and June 30, 2009, shows that diversification was effective over that period. An investor in a diversified 60/40 mix lost 18%, or about half as much as the all-stock index, which lost 35%*.

International investors were hit hard as well: The MSCI ACWI (All Country World Index) ex USA, which doesn't include the U.S. market, lost 37% and the MSCI Emerging Markets Index declined 36%. For the 2000-2002 bear market, an all-stock portfolio fell 47.4% while the 60/40 mix declined only 16.8%.

In fact, a diversified portfolio has helped investors weather market volatility over several different time periods. For the past three years, an all-stock portfolio lost 22.7% while the 60/40 mix declined only 5.4%. During the past five years, the stock portfolio lost 10.7% while the mix increased 4.7%. And as of June 30, 2009, over a full 10-year period, the stock portfolio lost 20.1% while the diversified mix gained 19.4% — an almost 40% advantage over stocks.**

Why Does Diversification Work?

The concept is based on the fact that returns for certain types of investments, or asset classes, tend to move in opposite directions. As a result, poor stock returns may be counterbalanced by investments in bonds, and vice versa.

You can diversify your portfolio by spreading your investments among different types of asset classes, such as U.S., international and emerging market stocks, bonds and also short-term money market investments. Exchange traded funds are an effective way to provide diversification since each individual fund holds hundreds of stocks and/or bonds.

It's important to remember, however, that the relationship between stock returns and bond prices isn't static. In volatile markets this relationship can become highly correlated, meaning returns for both types of investments move in the ame direction, which reduces the effectiveness of diversification. That's why a portfolio diversified among stocks and bonds still lost value during both recent bear markets. It's also why investments spread across U.S., international and emerging-market stocks didn't fare well either. All major investment sectors but one, government securities, declined.

The bottom line? While diversification doesn't eliminate the risks of investing and losses are possible in a diversified portfolio, diversification still works in many situations. As this challenging period for stock and bond markets continues, it's more important than ever to maintain a diversified portfolio. How you determine your investment mix depends on your age, financial situation, and when you'll need the money for important goals like retirement, college expenses or a down payment on a house.

It's a good idea to see if your diversified portfolio still reflects your financial situation and goals. If you lost your job in past months, you may need to consider adopting a more conservative investment mix, moving more of your money into bond funds and short-term money market investments. A new baby, a divorce or a retirement can also prompt changes in your diversified portfolio. If you've set up a 60/40 stock/bond investment mix but haven't changed it in a year, you may need to rebalance your portfolio since your equity-oriented mutual funds likely fell in price more than your income-oriented mutual funds in the past year. In this case, if you want to maintain your 60/40 mix, you'll have to sell some of your bond funds and invest the proceeds into equity funds.

* Stocks are represented by Standard & Poor's 500 Composite Index, a widely used measure of large U.S. stocks. Bonds are represented by Barclays Capital U.S. Aggregate Index, a respected measure of U.S. bonds.
**All returns in this paragraph are cumulative as of June 30, 2009.